The financial statements give an idea about the financial position of the company, however, it is discovered that there are some limitations of the financial statement analysis. The first limitation of it is that a financial statement ignores the productivity and the skills of the employee in an organization. In another word, we can say that looking at through the financial statement, there is no reflection of how well or bad our staffs or employees perform the work and we are unable to evaluate the skills which a company has through financial statement.
Financial statements give information about the financial position of the company hence; there are a number of users of the financial statements. Although the balance sheet, income statement, cash flow statement and changes in owners' equity give a crux of the profitability and activities of the company in one year but still there are some limitations of the financial statements. Firstly, although financial statements are prepared by following the International Accounting Standards but still the accounts names and terminologies can vary from state to state or company to company. This creates the confusions while comparing the financial statements. Secondly, balance sheets are based on historical cost methods and they do not give a fair idea of current company position. Thirdly, income statement is based on accrual basis therefore, it is considered more a fiction than a financial report. Moreover, a normal person who does not know the concepts of accounting may never able to understand the financial statements and the major investors in an economy are the households.This shows that financial statements can never help such people to understand the position of the company.
Financial statements give an idea about the financial position of the company, however, there are some limitations of the financial statements. The first limitation is that a financial statement ignores the productivity and the skills of the employees in an organization. Management Decision Analysis Report gives an idea about it but financial statements are unable to evaluate the skills which a company has. Secondly, balance sheet does not give timely and relevant information because it is based on historical costs and it does not give a fair idea about the current position of the company. There are different accounting measurement systems therefore, use of different techniques by different companies can make the comparisons of financial statements difficult. Moreover, income statement is considered a fiction because cash is king and income statement ignores this fact.
Financial statement analysis is a tool most credit managers use in evaluating credit risk. Credit risk comes in two basic forms:
1. The risk that a customer's business will fail resulting in bad debt write offs for its creditors, and
2. The risk that the customer will pay slowly.
Many credit managers perform financial statement analysis without understanding its limitations. These are some of the limiting factors credit managers must keep in mind:
* Past financial performance, good or bad, is not necessarily a good predictor of what will happen with a customer in the future.
* The more out-of-date a customer's financial statements are, the less value they are to the credit department.
* Without the notes to the financial statements, credit managers cannot get a clear picture of the scope of the credit risk they are considering.
Limitations of financial Statement Analysis are given below: Limitations of Financial Statement Analysis 1. There will be no doubt in this statement that ratios are a useful analysis tool, there are certain limitations, which are very important for an analyst to understand before applying this tool, in order to make his analysis more meaningful and significant. 2. FSA (Financial Statement Analysis) is generally an outdated (because of Historical Cost Basis) post-mortem of what has already happened. It is simply a common starting point for comparison. Always use Constant Rupee / Dollar analysis to account for inflation or increase. 3. FSA is limited by the fact that financial statements are "window dressed" by creative accountants. Window dressing refers to the understatement or overstatement of financial facts.
4. Different companies use different accounting standards for Inventory, Depreciation, etc. Therefore comparing their financial ratios can be misleading FSA just presents a few static snapshots of a business' financial health but not the complete moving picture. 5. It is very difficult and not easy to say based on Financial Ratios whether a company is healthy or not because that depends on the size and nature of the business.
